Managing Earnings … or Cooking the Books?

How firms make the numbers with creative accounting

Accounting is the language of business. Information found in financial statements is employed daily in various forms of analysis and decision making by a worldwide business community. Bankers use it to determine whether or not a client should be extended a loan, and what the terms will be if the loan is granted. Investment bankers use it to analyze the potential for mergers, acquisitions, asset sales and purchases, and to raise debt and equity in capital markets. Consultants use it to formulate their clients’ strategies based on competitive analysis. Buy-side securities analysts use it for ferreting out potential investments for their clients’ portfolios. Managers use it to monitor their firm’s current performance, analyze prospective investment opportunities, and to determine appropriate financing policies. Boards of directors use it to create compensation packages for the firm’s managers and to monitor the managers’ performance.

But just how reliable is the information provided in a firm’s financial statements? In this era of openly managing earnings, Arthur Levitt, chairman of the SEC, has been asking himself the same question. His conclusion: some managers are distorting the economic reality of their firm’s performance through “accounting hocus-pocus,” which is being greeted by the business community with nothing more than “nods and winks.”

Mary Jo White, U.S. Attorney of New York’s Southern District, doesn’t use the polite term “managed earnings;” to her its simply accounting fraud or cooking the books (Loomis, Carol J., Lies, Damned Lies, and Managed Earnings, Fortune, August 2, 1999, pages 76-77). Together, Levitt and White intend to “clean-up” the financial reporting of public companies. But many corporate executives are quick to defend the means for achieving what is perceived as management’s obligation to “make the numbers.”

Making The Numbers

Making the numbers means managers are focused on producing earnings per share (EPS) at least as large as the estimated EPS generated by analysts in Wall Street firms. Why should managers worry about external “hurdles” placed before them by outside analysts? Because shareholders no longer live in a buy-and-hold world. Day-traders, among others, want to know what will happen to a stock’s price in the next few minutes, or at least by tomorrow. Institutional money managers are concerned about whether the firms in their portfolios are going to “make the quarter.” Since analysts are perceived by the market at large as experts at gathering and processing information, one recommendation from a prominent analyst can send a firm’s stock price several points higher or lower in a matter of hours, if not minutes.

A firm’s stock price, (or equity value which is equal to price per share multiplied by shares outstanding), influences everything. For example, favorable price movement over reasonable periods of time can impact a firm’s long-term financing decisions by attracting new equity investors, opening new credit markets, or by qualifying for better ratings and terms. The same is true for short-term financing as vendors will be increasingly willing to extend beneficial terms and contract structures. Favorable stock price performance also creates the opportunity to expand through acquisitions, whereas unfavorable performance increases the odds of becoming a takeover target and the eventual loss of control of the firm. Finally, higher stock prices usually translate into higher compensation for executives and employees, which helps retain and attract the talent needed to remain competitive.

Guidance

So how do managers make the numbers? In addition to operating a competitive firm, managers have at least two other ways to hit the EPS target. The first method is often referred to as guidance. Guidance involves interaction between a company spokesman and the analysts who follow the firm. The spokesman will give a set of vague projections to assist analysts in creating next quarter’s projections without divulging what is happening inside the firm. For example, a spokesman may suggest that in the next quarter the firm’s revenue will be higher or lower, that expenses may be increasing or decreasing, or that taxes may be changing. Guidance has become a primary line of communication between firms and their analysts.

Because the firm’s information is disseminated through the market without giving an individual or single entity an advantage, investors are viewed as playing on a level field and the number of lawsuits and SEC interference is minimized. Guidance also fosters uniformity for the analysts’ estimates which helps keep the consensus where the firm wants it. Now, the key question is: How do managers get their EPS to that consensus number?

Generally Accepted Accounting Principles

This brings us to the second method of “making the numbers:” managing earnings. To deter managers from disguising the economic reality of their firm’s performance for self-serving purposes, and to foster uniformity in reporting, several accounting conventions known as Generally Accepted Accounting Principles (GAAP) have been developed by standards boards throughout the world. While accounting standards vary from country to country, the intent of GAAP is to encourage managers to record similar economic transactions in consistent ways across firms and over time.

GAAP is not so rigid that it offers managers only one choice for every recording decision. For example, within GAAP guidelines managers have several alternatives when deciding how to depreciate assets. Depreciation choice will speed up or slow down expense recognition, which in turn, will reduce or increase income. However, because accrual accounting deals with expectations of the future, GAAP is founded in conventions of conservatism and measurability to help reduce distortions that may arise from over-optimism.

While GAAP offers a comprehensive set of guidelines within which managers have to operate, there are some important limitations to the rules. One of the most prominent concerns is assets and liabilities that do not appear on the balance sheet. Compounding this problem is the inability to value these off-balance sheet items. For example, missing from Coca Cola’s balance sheet is the value of its brand name. The value of Microsoft’s market position is nowhere to be found in its financial statements. Estimates of the value of these assets are found by looking at the divergence between the market price per share and the book value per share. But included in the difference of these two measures are the value of employees, marketing campaigns, and R&D.

As far as GAAP is concerned, money invested in employee training, advertising and promotion, and R&D (the oil industry is a notable exception) is an expense, not an investment, and therefore, this economic asset is not an asset in the accounting sense. Immediately expensing these investments reflects the conservatism mentioned above as there is no way of knowing if, or when, these investments will payoff in the future.

Another primary concern is the conspicuous inconsistency related to accounting for mergers and acquisitions. For example, as noted above, most firms have to expense the advertising related to building a brand name. However, if that same brand name is acquired by purchasing another firm, it becomes an asset and will be written-off over time rather than expensed immediately. Alternatively, firms may merge through pooling accounting where the value of the “acquired” brand is again ignored by accounting conventions and left up to the market to value. (For more information on the debate about pooling see the article by Michael Davis in this issue.)

Accounting Techniques Used To Manage Earnings

Because of limitations and inconsistencies in GAPP’s standards and the flexibility built into the system, managers have some latitude when making accounting decisions that will drive earnings results. With this latitude, firms can systematically use methods that consistently report lower expenses or higher revenues. Thus, managers can manipulate quarterly earnings to some degree and therefore maintain the ability within the rules of GAAP to “make the numbers.” Following are examples of accountings techniques that have been used to manage earnings.

Revenue Recognition

The Revenue Recognition principle dictates that revenue be recognized in the period it is earned. Companies in need of earnings often find it convenient to be aggressive in recognizing revenue. This practice was popularized by start-up producers of hi-tech hardware. The motivation was to show earnings in order to obtain external financing. It was adopted by many software companies because the point at which revenue was earned became blurred. Most recently the SEC has begun looking at internet start-up firms who have been recognizing revenue at the beginning of a contract, long before it is earned.

The opposite approach is often taken by successful companies who put sales into a liability account called unearned revenue. Their motivation is to maintain a steady growth in earnings. During a slow quarter, the company will reduce the unearned revenue account and recognize revenue. For examples of companies who employ resourceful revenue recognition, please see the following:

King, Ralph T. Jr., McKesson, Finding More Improprieties In Accounting, to Restate Profit Again, Wall Street Journal May 26, 1999, pages A3 and A4. (Available to current Pepperdine students through the Dow Jones Interactive service on the Pepperdine University Library Home Page)

Restructuring Charges

It is a rare day when the Wall Street Journal does not include information on a company announcing a restructuring charge. The reasons given cover every possible business situation. Successful companies use it to provide steady increases in earnings. If a company experiences a one-time gain, it might record a restructuring charge to offset the gain. An example would be the gain on the sale of a factory or other operating unit. This gain will very likely be accompanied by restructuring charges offsetting the gain. The company will announce that the sale of the unit presents a number of potential future costs such as expenses for the relocation of employees or the replacement of systems that were at the sold unit but shared by other operating units.

In the first quarter of 1999, there were 128 restructuring write-offs totaling $3 billion reported in the Wall Street Journal. For examples of the use of restructuring charges please see the following:

Fox, Justin, Learn To Play The Earnings Game, Fortune, March 31, 1997.

Keeping Debt in Subsidiaries In Which the Parent Owns Less Than 50 Percent

Carrying a high debt ratio on the balance sheet results in a less favorable credit rating and higher interest rates. A company wanting to avoid consolidation of a highly leveraged subsidiary in which it has a substantial investment would need to keep its ownership interest below 50 percent. The company then uses the equity method of recognizing these subsidiaries’ operating results, which keeps their assets and their debt off the parent’s books. For an example of a company making successful use of this technique please see:

Fink, Ronald, Balancing Act, CFO Magazine June 1999

Write-off Of Purchased Research and Development

An increasingly common practice in accounting for acquisitions, especially in technology companies, is to write off in-process research and development. Under this technique, acquirers take large, immediate charges against earnings to reflect R&D underway at the target company at the time of takeover. The write-off is justified under the theory that the research might never find a commercial application and thus is of doubtful value as an asset. One might opine that the real motivation is to reduce the amount of goodwill that the acquirer must put on the balance sheet and write off against earnings over a period of time.

During 1998, U.S. companies took 247 write-offs for in-process R&D totaling $19.6 billion. During the first quarter of 1999, there were 32 such write-offs totaling $1.3 billion. The SEC has begun clamping down on these write-offs, with the result that many firms have had to reduce amounts assigned to in process research and development. For a related story please see:

Condon, Bernard, Gaps in GAAP, Forbes, January 25, 1999, pages 76-80.

Materiality

The accounting principle of materiality indicates that an item must be reported if it is likely to influence the decision of a reasonably prudent investor or creditor. A company might include a one-time gain in earnings and not identify this as a one-time gain and claim that the amount is not material. For examples of this practice please see:

Financed Area Developers

Financed area developers, or FADs, are large-scale franchisees that act a lot like subsidiaries but aren’t. If they were, the franchiser would be required to consolidate their financial results. Instead they are disclosed, only on an annual basis, deep in the text of the company’s SEC filings. The FADs get their startup capital from the franchiser, and with that money they pay the franchiser royalties, franchise fees, and interest that allow the franchiser to report ever-rising profits. The net effect is that the franchiser reports as revenue, amounts of cash that it has parked in the FAD; however, none of the expenses of the FAD appear on the financial statements of the franchiser. For an example of a company using the FAD technique please see:

Fox, Justin, Learn To Play The Earnings Game, Fortune, March 31, 1997

Realizing One Time Gains and One time Losses in the Same Period

This technique is a close cousin of the Restructuring Charge technique, but it involves two unrelated transactions. A company realizes a one-time gain and offsets that gain with an unrelated write-off. In essence, it is saving the gain for a period in which it is short on earnings. For an example of this technique please see:

Matching

The accounting principle of matching requires that a company record costs and expenses in the same period as the revenue that the costs and expenses produce. There have been instances in which companies improperly delay the recording of period costs and later claim that these costs produce revenue in future periods. For an example of this technique please see:

Putting Research and Development Expenses at a Subsidiary

In the pharmaceutical industry, a great deal of money is poured into R&D. To keep these R&D expenses off the income statement, the company forms a new company, parks some cash in it, and spins it off to shareholders. The newly formed company then hires the founding company to develop drugs for it, reimbursing the founding company for its costs. The founding company retains the right to buy the newly formed company, does so at a fraction of the original cash amount, and dissolves it. So for a price equal to a fraction of its original investment, the company is able to pick and choose the most promising new drugs and dump the failures. For an example of this technique please see:

Conclusion

These examples are only the tip of the iceberg. What is the lesson to be learned from this accounting slight of hand? In a perfect world, managers would record transactions in the manner that best reflects the underlying economics of the firm. In our imperfect world, many managers try to provide meaningful, if not unambiguous, financial information to the market. Others are not as candid, and still others are down right deceptive. Because capital markets, labor markets, and product markets all rely on this data when contracting with the firm, the firm’s value will be very sensitive to changes in the perceived quality of the data. As potential or actual shareholders and employees, it would behoove us to spend considerable time analyzing a firm’s financial reports, or at least the reports of those who have the ability to analyze financial statements with some degree of sophistication. For additional examples and related stories please see:

Bartlett, Sarah, Who Can You Trust?, Business Week, October 5, 1998, pages 133-142.

About the Author(s)

Steven R. Ferraro, CFA, PhD, is an associate professor of finance at Pepperdine's Graziadio School of Business and Management where he teaches corporate finance, valuation and corporate combinations, and investments. His current research interests include corporate restructuring, event-driven investing, and real estate investment trusts. Dr. Ferraro is managing director of the Center for Valuation Studies and principal of Ferraro Capital Management. He holds a PhD from Louisiana State University and is a Chartered Financial Analyst (CFA). He is also a recent recipient of the Howard A. White teaching award.